Tuesday, December 14, 2010

Fed's poor leadership leaves bond market open to speculative attack!



Back in November when the Fed announced its intention to unleash QE2, they said they would purchase an additional $600 bln of longer term securities. There was no mention of why or how they came up with that number. It almost seems completely arbitrary.

In reading the minutes of that meeting you could surmise that they had two reasons for the move. First, they thought they needed to take action to "promote a stronger pace of economic growth." But where were the guarantees that said buying an additional $600 bln in longer term maturities promoted stronger growth?

There were none.

The second reason given was that they wanted to keep the face value of the securities in their portfolio constant. Apparently they were worried that principal payments on existing agency and MBS securities would lower the overall amount of securities on their balance sheet. So what? Did they believe that would cause interest rates to rise? If they did, there was no explicit mention of that.

Nowhere in the minutes of that meeting was there any discussion of wanting to target a desired interest on longer-term maturities. NOWHERE! It never came up. Instead, the committee members just pulled some seemingly arbitrary number out of a hat--$600 bln--and assumed that's all they needed to do. Pardon my generalization, but it had all the look and feel of throwing something up on a wall and hoping that sticks.

Truth be told, if the FOMC had simply said that it wanted 10-year Treasury yields to be at 2% and that the Fed was going to buy those maturities until it reached that desired interest target, then that's what they would have gotten, with probably far less than $600 billion.

However, by focusing on quantity ($600 bln) instead of price (say, 2%), they left the bond market wide open to speculation. That's what's going on now, speculation. Thnk about it...10-yr Treasury note futures trade a notional amount of about $80 bln per day! Multiply that times 30 days in a month and that's $2.4T notional! That's 30 times more than the $75 bln per month the Fed said it was going to buy. Speculators can easily push bond prices down and yields up in response to the Fed's tepid and ill-thought-out buying program. That's exactly what they are doing.

It's an astonishing thing to say, but the people on the Board of Governors totally lack an understanding of the one thing that the Fed has absolute control over--interest rates. This is truly mindboggling. The members of the FOMC have left the bond market open to speculative attack as a result of their ignorance. And to make matters worse, there will be plenty of negative fallout from this because the commentary that will swirl about--people will be saying that inflation is surging, that the Chinese are selling our debt, that the national debt is skyrocketing, that the dollar is the cause, etc--will completely distort the truth and make policy more ineffective than ever. That means the outcomes will be even more disruptive. The FOMC has 12 members. None of them understood this???? Sadly, that's a correct statement.

20 comments:

welfarewarfare state said...

Mike,

We agree that the Fed Board of Governors is incompetent but for different reasons.

You mentioned that the Fed's $600 billion dollar program was arbitrary, and ask where did that number come from. The Fed announced that they will be making these purchases through next summer--about 7 months. It might just be coincidence, but the projected deficit for the next 7 months is projected to be about $600 billion dollars. Maybe it's not so arbitrary.

I dont' agree with you when you assert that the Fed has absolute power over interest rates. The only rate that they can absolutely control is the Fed Funds Rate. They certainly can steer interest rates in the short term, but this power has limits too.

Some of us have been saying contra-MMT'ers that QE2 would mean higher interest rates eventually. The Fed has sent everyone the message that they are going to monetize our debt. Interest rates must rise to reflect the added risk of currency debasement. The Fed Board of Governors is going to find out that the market is still stronger than they are.

P.S. Remember that bet I made with you about a month ago about 10 year Treasury yields being 10% by November of 2012? Looks like it will be happening sooner than that. Will you be pinning the blame on speculators when it happens?

Mike Norman said...

All rates are anchored by Fed policy.

The bet's still good.

macrosam said...
This comment has been removed by the author.
macrosam said...

WW, operationally what the Fed does to target Fed Funds is not very different than what it needs to do to target rates further out the yield curve aside from, obviously, the longer maturity securities involved. If they applied non-discretionary buying/selling to longer maturities, the process and effect would be the similar regarding the Fed's activity.

Mike, one thing I do disagree on is that the Fed does get it. Bernanke even explicitly mentioned setting rate targets at longer maturities in 2002 but I believe he is refraining from doing so due to political backlash/uncertainty. I can quote/cite his comments from that time shortly (have to find the research piece).

macrosam said...

I also posted this on your Facebook page but this is from Bernanke's 2002 speech:

“So what might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure --that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt.”

macrosam said...

WW, I just want to make sure you understand that higher interest rates are often supportive of a stronger currency from just the cost of carry perspective alone, not to mention the attraction towards higher yielding investments. This is one of the reasons many of these Emerging Markets are finding that their interest rate hikes have been counterproductive regarding slowing down capital inflows (and now they're trying capital controls and raising taxes on foreign investment next). When you hike rates, that makes me want to own your currency even more.

welfarewarfare state said...

macrosam,

I don't think we are disagreeing on that much. Rising interest rates do often mean a strengthening currency. I am aware that when the Fed wants to move interest rates higher they contract the credit money supply. That isn't what they are trying to do here. The Fed stated publicly that they are pursuing QE2 to keep interest rates low. The market isn't responding how they hoped though.

You are right when you claim that higher interest rates often encourage flight into that currency. However, the Fed obviously wants our borrwoing costs low because we have so much debt. Much of this debt is financed with 2 year Treasuries. When bond prices spike--look out!

I do think it is laughably absurd that some market commentators on business networks think that the rates are rising because they think investors are optimistic about economic growth which leads them to believe that the Fed won't have to pursue more QE. This is nonsense.

Mike Norman said...

macro,

maybe you're right. It would just be nice for a change that some policymaker told it like it is, without the constraint of political expediency

Airelon said...

Do you seriously misunderstand the point and purpose of QE2 Mike?

It's not only working, it's working BEAUTIFULLY ...

D

googleheim said...

bernanke said himself that he can raise and lower interest rates at his call, his whim.

that means his underlings do not even listen and understand their boss.

that's the scary part.

Matt Franko said...

Goog,

I bet you are right. Mike has pointed out that it is called "quantitative" easing so it is about quantity not price for them.

Bernanke probably has killed those brain cells that held the details of the speech Macro has pointed out above.

No way to prove it but I bet if you could look into it the Fed has been bidding below the market price of the bonds to "get the better price" ie lower price on their bond purchases.

It's human instinct to get the best price. If you are a Monetary Policy setter though, you have to run counter to this instinct, it's counter-intuitive, this is where the underlings are screwing up....

They are probably the biggest buyer in the bond market these days. They have to be. At 110B/mo like welfare sez, they are buying all of the new NFAs as this is the current flow of the deficit. Bank credit is still contracting so that horizontal channel is cut off.

If the biggest buyer (and that buyer is also a Monopolist in the same market) is consistently bidding below the offer, I think prices go down...

Bonds may not rally until the Fed stops this. Theis is what happened after QE1, huge bond rally from April to end of August when the Fed rolled out QE2 at their conference at the Jackson Hole... ever since then bonds have sold off.

Mike is right that these people are morons and dangerous to the rest of us.

This just out this AM:
"Demand for mortgages in the U.S. fell last week as interest rates jumped to their highest level in about six months, industry data revealed Wednesday morning."

These are the highest rates we've had since the end of QE1. This is what the first month of QE2 has given us.

Bottom line: The Fed is RAISING interest rates becasue they are the largest buyer and are consistently bidding below the offer. Nothing else can happen in this situation.

Mike Norman said...

Airelon,

How is it working? You mean it was the Fed's intention to RAISE bond yields? If that's so, then they went about it in a very non-conventional way.

googleheim said...

Bernanke's 60 minutes Part II
interview a week or so ago has the quote directly

bubbleRefuge said...

From a Dr. Fullwiler white paper

Recall also that Friedman’s “puzzle” was primarily concerned with how other rates in the economy are affected given that open market operations are relatively insignificant in dollar terms. Changes to the federal funds rate target affect other short-term rates because, as already noted, bank borrowing or lending in the federal funds market can substitute for the commercial paper, negotiable time deposit, Eurodollar, repurchase agreement, and short-term Treasury markets. Aside from small differences due to collateral, default risk, and so forth, rates in these markets move together via arbitrage (Griffiths and Winters 1997; Meulendyke 1998, ch. 3; Cyree et al 2003; Lee 2003; Demiralp et al 2004).10 Long-term Treasury rates are known to be primarily influenced by expectations of future short term rates—once an additional ‘risk’ or ‘liquidity’ premium on long-term rates is accounted for. This provides another answer to Friedman’s “puzzle”: the Fed can influence other rates simply by setting and sustaining the federal funds rate alone; it generally makes no attempt to intervene directly in other markets—regardless of the dollar volume of trades in these markets—since some manner of arbitrage against the Fed’s target occurs in each.

Matt Franko said...

I think we have speculators selling the bonds, and the incompetent Fed is the largest buyer and is consistently bidding below the offer and this is crushing bond prices.

macrosam said...

We had a two year overweight position in bonds and now those holders are terrified of capital losses whether driven by position unwinds, fiscal stimulus, stabilizing data, year-end liquidity drops exacerbated by aligned fiscal year-ends (due to bank holding co. status, no more 11/30 year-ends, now all 12/31), etc. But look at yields on German Bunds, JGBs, those have risen at the same time US Treasury yields have as well (though the yield spread has widened more in USTs). It's not just a US Treasury event.

macrosam said...

There was a 62.5% probability of a Fed rate hike being priced in the Nov 2011 Fed Fund futures (at least this morning). I'd fade that. The Fed can't raise rates. I suspect the Fed will go through its sequence of buybacks to take duration risk/exposure out of the banks and then if rates continue to rise despite the lack of any rate hike, Ben will explicitily announce the interest rate ceilings.

hiljaa said...

a very interesting new video regarding schiff's investment performance.

http://www.youtube.com/watch?v=YtIoev21Yhw

Matt Franko said...

Macro,
"the Fed will go through its sequence of buybacks to take duration risk/exposure out of the banks "

There is no way they are that smart/proactive imo. That said do you have any evidence of this? ie If they are so smart why didnt they proactively act to prevent the GFC in the first place?

Resp,

Mike Norman said...

Matt is right. The Fed is buying "scale down" and in effect, causing the selloff. They're doing this because they're fixated on quantity ($600 bln) as opposed to price (interest rate). I remember when I was a floor trader. I had clients in the oil business--big firms--who would sometimes want to protect a certain price. They'd give me an order that would be, "Buy 100 (crude), 'worst.'" That meant buy it up...aggressively. When Japan used to actively intervene in FX markets, they wouldn't scale down their dollar buying (or sell yen scale up), they'd buy dollars aggressively to put the USD/JPY exchange rate to a certain level. The Fed is not doing this. By signaling to the market that they will buy scale down, they are actually creating this selloff as nervous longs look to sell before the largest buyer lowers its bid again and as speculative shorts compete for a better price.